HKAS 11, 18 and May 2007

Transcription

1 HKAS 11, 18 and May 2007 Nelson Lam 林智遠 MBA MSc BBA ACA CFA CPA(Aust) CPA(US) FCCA FCPA(Practising) MSCA Nelson 1 Tonight s Agenda Revenue (HKAS 18) Construction Contracts (HKAS 11) Borrowing Costs (HKAS 23) Simple but Comprehensive Contentious and key issues Real Life Cases and Examples HK Interpretation 3 HK Interpretation Nelson 2 1

2 Revenue (HKAS 18) Nelson 3 Revenue What is it? Income is defined in the Framework for the Preparation and Presentation of Financial Statements as: increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Income encompasses both revenue and gains. Revenue is income that arises in the course of ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends and royalties Nelson 4 2

3 Revenue What is it? Revenue includes only the gross inflows of economic benefits received and receivable by the entity on its own account. Amounts collected on behalf of third parties such as sales taxes, goods and services taxes and value added taxes are not economic benefits which flow to the entity and do not result in increases in equity. Therefore, they are excluded from revenue. Similarly, in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission Nelson 5 Revenue What is it? Example What is the difference between Revenue and Turnover? No definition of turnover in HKFRS and the Companies Ordinance However, Footnote to HKAS 1.81 states that: Hong Kong incorporated companies are required to disclose 1. turnover for the financial year and 2. the method by which it is arrived at (HKCO Tenth Sch. para 16). Turnover should consist of revenue arising from the principal activities of the entity and therefore should not usually include those items of revenue and gains that arise incidentally Nelson 6 3

4 Revenue Recognition Issue The primary issue in accounting for revenue is determining when to recognise revenue. Revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. HKAS 18 identifies the circumstances in which these criteria will be met and, therefore, revenue will be recognised. It also provides practical guidance on the application of these criteria Nelson 7 Revenue Measurement Revenue shall be measured at the fair value of the consideration received or receivable. Fair value of consideration received/receivable Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. The amount of revenue arising on a transaction is usually determined by agreement between the entity and the buyer or user of the asset. It is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity. In most cases, the consideration is in the form of cash or cash equivalents and the amount of revenue is the amount of cash or cash equivalents received or receivable Nelson 8 4

5 Revenue Measurement Discounting required when inflow deferred When the inflow of cash or cash equivalents is deferred, the fair value of the consideration may be less than the nominal amount of cash received or receivable. Example: An entity may provide interest free credit to the buyer or accept a note receivable bearing a below-market interest t rate from the buyer as consideration for the sale of goods. When the arrangement effectively constitutes a financing transaction, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest. The imputed rate of interest is the more clearly determinable of either: a) prevailing rate for a similar instrument of an issuer with a similar credit rating; or b) a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services. The difference between the fair value and the nominal amount of the consideration is recognised as interest revenue Nelson 9 Revenue Measurement Case Sino Land Company Limited 2005 Annual Report stated that: Where properties are sold under deferred terms, the difference between the sales prices with and without such terms is treated as deferred interest income and is released to the income statement on a straight line basis over the repayment period commencing from the completion of the relevant sales agreements. Same as HKAS 18? Nelson 10 5

6 Revenue Measurement Example Sales in Deferred Terms On , Entity A sells a motor car to X at HK$66,200 by accepting the payments in the following terms: Down payment HK$ 20,000 Repayment on ,000 Repayment on ,200 Assumed that the imputed rate of interest for Entity A is 10%. Calculate the interest elements. The interest element is HK$ 6,200 (to be deferred). Cash flow Discount factor Present value $ 20,000 1 / (1 + 10%) 0 $ 20, $ 22,000 1 / (1 + 10%) 1 $ 20, $ 24,200 1 / (1 + 10%) 2 $ 20,000 Fair value of the consideration $ 60, Nelson 11 Revenue Measurement Different from HKAS 16, 38.. Exchange of goods or services Similar Dissimilar 1. Similar goods or services When goods or services are exchanged or swapped for goods or services which are of a similar nature and value, the exchange is not regarded as a transaction which generates revenue. This is often the case with commodities like oil or milk where suppliers exchange or swap inventories in various locations to fulfil demand on a timely basis in a particular location Nelson 12 6

7 Revenue Measurement Different from HKAS 16, 38.. Exchange of goods or services Similar Dissimilar 2. Dissimilar goods and services When goods are sold or services are rendered in exchange for dissimilar goods or services the exchange is regarded as a transaction which generates revenue. The revenue is measured at the fair value of the goods or services received, adjusted by the amount of any cash or cash equivalents transferred. When the fair value of the goods or services received cannot be measured reliably the revenue is measured at the fair value of the goods or services given up, adjusted by the amount of any cash or cash equivalents transferred Nelson 13 Identification of the Transaction The recognition criteria in HKAS 18 is usually applied separately to each transaction. However, there are situations that the recognition criteria is: 1. Applied to separately identifiable components of a single transaction 2. Applied to two or more transactions together Separately identifiable component of a single transaction Two or more transactions together Nelson 14 7

8 Identification of the Transaction Example In certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. Separately identifiable component of a single transaction For example when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed Nelson 15 Identification of the Transaction Example Conversely, the recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. For example an entity may sell goods and, at the same time, enter into a separate agreement to repurchase the goods at a later date, thus negating the substantive effect of the transaction; in such a case, the two transactions are dealt with together. Two or more transactions together Nelson 16 8

9 Revenue Covered in HKAS 18 Sale of goods Rendering of services Interest, royalties and dividend HKAS 18 shall be applied in accounting for revenue arising from the following transactions and events: a) the sale of goods; b) the rendering of services; and c) the use by others of entity assets yielding interest, royalties and dividends Nelson 17 Revenue Sale of Goods Main Principle Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied: a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; c) the amount of revenue can be measured reliably; d) it is probable that the economic benefits associated with the transaction will flow to the entity; and e) the costs incurred or to be incurred in respect of the transaction can be measured reliably Nelson 18 9

10 Revenue Sale of Goods Main Principle The assessment of when an entity has transferred the significant risks and rewards of ownership to the buyer requires an examination of the circumstances of the transaction. In most cases, the transfer of risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. This is the case for most retail sales. In other cases, the transfer of the risks and rewards of ownership occurs at a different time from the transfer of legal title or the passing of possession Nelson 19 Revenue Sale of Goods Main Principle Several situations should be placed attention, including A. The entity retains significant risks of ownership B. The entity retains only insignificant risk of ownership C. Inflow of future economic benefits may not be probable D. Revenue and expenses relating to the same transaction Risk of ownership Other situations Nelson 20 10

11 Revenue Sale of Goods Sale and repurchase agreements (other than swap transactions) under which the seller concurrently agrees to repurchase the same goods at a later date, or when the seller has a call option to repurchase, or the buyer has a put option to require the repurchase, by the seller, of the goods Any difference if the goods involved are financial assets. Example Nelson 21 Revenue Sale of Goods Example 1. For a sale and repurchase agreement on an asset other than a financial asset the terms of the agreement need to be analysed to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer and hence revenue is recognised. When the seller has retained the risks and rewards of ownership, even though legal title has been transferred the transaction is a financing arrangement and does not give rise to revenue. 2. For a sale and repurchase agreement on a financial asset HKAS 39 applies Nelson 22 11

12 Revenue Sale of Goods Example Goods shipped subject to conditions: a) Installation and inspection Example - the installation of a factory tested television receiver which only requires unpacking and connection of power and antennae Example - shipments of iron ore, sugar or soya beans. Revenue is normally recognised when the buyer accepts delivery, and installation and inspection are complete. However, revenue is recognised immediately upon the buyer s acceptance of delivery when: i) the installation process is simple in nature, or ii) the inspection is performed only for purposes of final determination of contract prices Nelson 23 Revenue Sale of Goods Example Goods shipped subject to conditions: b) On approval when the buyer If there is uncertainty about the has negotiated a limited right possibility of return, revenue is of return recognised when the shipment has been formally accepted by the buyer or the goods have been delivered and the time period for rejection has elapsed. c) Consignment sales under which the recipient (buyer) undertakes to sell the goods on behalf of the shipper (seller) d) Cash on delivery sales Revenue is recognised by the shipper when the goods are sold by the recipient to a third party. Revenue is recognised when delivery is made and cash is received by the seller or its agent Nelson 24 12

13 Revenue Sale of Goods Entity Retains Only Insignificant Risks of Ownership If an entity retains only an insignificant risk of ownership the transaction is a sale and revenue is recognised. For example, a seller may retain the legal title to the goods solely to protect the collectibility of the amount due. In such a case, if the entity has transferred the significant risks and rewards of ownership, the transaction is a sale and revenue is recognised. Another example of an entity retaining only an insignificant risk of ownership may be a retail sale when a refund is offered if the customer is not satisfied. Revenue in such cases is recognised at the time of sale provided the seller can reliably estimate future returns and recognises a liability for returns based on previous experience and other relevant factors Nelson 25 Revenue Sale of Goods Example "Bill and hold" sales, in which delivery is delayed at the buyer s request but the buyer takes title and accepts billing. Revenue is recognised when the buyer takes title, provided: a) it is probable that delivery will be made; b) the item is on hand, identified and ready for delivery to the buyer at the time the sale is recognised; c) the buyer specifically acknowledges the deferred delivery instructions; and d) the usual payment terms apply. Revenue is not recognised when there is simply an intention to acquire or manufacture the goods in time for delivery Nelson 26 13

14 Revenue Sale of Goods Inflow of Future Economic Benefits Not Probable Revenue not recognised if inflow is not probable Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. In some cases, this may not be probable until the consideration is received or until an uncertainty is removed. For example, it may be uncertain that a foreign governmental authority will grant permission i to remit the consideration from a sale in a foreign country. When the permission is granted, the uncertainty is removed and revenue is recognised Nelson 27 Revenue Sale of Goods Example Lay away sales under which the goods are delivered only when the buyer makes the final payment in a series of instalments Revenue from such sales is recognised when the goods are delivered. However, when experience indicates that most such sales are consummated revenue may be recognised when a significant deposit is received provided the goods are on hand, identified and ready for delivery to the buyer Nelson 28 14

15 Revenue Sale of Goods Inflow of Future Economic Benefits Not Probable Inflow is not probable after revenue is recognised When an uncertainty arises about the collectibility of an amount already included in revenue the uncollectible amount or the amount in respect of which recovery has ceased to be probable is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised. No offsetting Nelson 29 Revenue Sale of Goods Matching of Revenues and Expenses Revenue and expenses that relate to the same transaction or other event are recognised simultaneously this process is commonly referred to as the matching of revenues and expenses. Expenses, including warranties and other costs to be incurred after the shipment of the goods can normally be measured reliably when the other conditions for the recognition of revenue have been satisfied. However, revenue cannot be recognised when the expenses cannot be measured reliably; in such circumstances, any consideration already received for the sale of the goods is recognised as a liability Nelson 30 15

16 Revenue Rendering of Services Sale of goods Rendering of services Interest, royalties and dividend Nelson 31 Revenue Rendering of Services Main Principle When the outcome of a transaction involving the rendering of services can be estimated reliably revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the balance sheet date. Often referred to as the percentage of completion method The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: a) the amount of revenue can be measured reliably; b) it is probable that the economic benefits associated with the transaction will flow to the entity; c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably Nelson 32 16

17 Revenue Rendering of Services Under the percentage of completion method revenue is recognised in the accounting periods in which the services are rendered. The recognition of revenue on this basis provides useful information on the extent of service activity and performance during a period. HKAS 11 Construction Contracts also requires the recognition of revenue on this basis. The requirements of HKAS 11 are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services Nelson 33 Revenue Rendering of Services Example Installation fees Installation fees are recognised as revenue by reference to the stage of completion of the installation unless they are incidental to the sale of a product in which case they are recognised when the goods are sold. Advertising commissions Media commissions are recognised when the related advertisement or commercial appears before the public. Production commissions are recognised by reference to the stage of completion of the project Nelson 34 17

18 Revenue Rendering of Services Inflow of Future Economic Benefits Not Probable Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in revenue the uncollectible amount, or the amount in respect of which recovery has ceased to be probable, is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised. No offsetting Nelson 35 Revenue Rendering of Services Reliable Estimates of Revenue An entity is generally able to make reliable estimates after it has agreed to the following with the other parties to the transaction: a) each party s enforceable rights regarding the service to be provided and received by the parties; b) the consideration to be exchanged; and c) the manner and terms of settlement. It is also usually necessary for the entity to have an effective internal financial budgeting and reporting system. The entity reviews and, when necessary, revises the estimates of revenue as the service is performed. The need for such revisions does not necessarily indicate that the outcome of the transaction cannot be estimated reliably Nelson 36 18

19 Revenue Rendering of Services Stage of Completion of a Transaction The stage of completion of a transaction may be determined by a variety of methods. An entity uses the method that measures reliably the services performed. Depending on the nature of the transaction, the methods may include: a) surveys of work performed; b) services performed to date as a percentage of total services to be performed; or c) the proportion that costs incurred to date bear to the estimated total costs of the transaction. Only costs that reflect services performed to date are included in costs incurred to date. Only costs that reflect services performed or to be performed are included in the estimated total costs of the transaction. Progress payments and advances received from customers often do not reflect the services performed Nelson 37 Revenue Rendering of Services Indeterminate Number of Acts and Significant Specific Act For practical purposes, when services are performed by an indeterminate number of acts over a specified period of time, revenue is recognised on a straight-line basis over the specified period unless there is evidence that some other method better represents the stage of completion. When a specific act is much more significant than any other acts, the recognition of revenue is postponed until the significant act is executed Nelson 38 19

20 Revenue Rendering of Services Servicing fees included in the price of the product Example When the selling price of a product includes an identifiable amount for subsequent servicing (for example, after sales support and product enhancement on the sale of software) that amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement together with a reasonable profit on those services Nelson 39 Revenue Rendering of Services Outcome of Services Not Estimated Reliably When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable. During the early stages of a transaction, it is often the case that the outcome of the transaction cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover the transaction costs incurred. Therefore, revenue is recognised only to the extent of costs incurred that are expected to be recoverable. As the outcome of the transaction cannot be estimated reliably, no profit is recognised Nelson 40 20

21 Revenue Rendering of Services Outcome of Services Not Estimated Reliably When the outcome of a transaction cannot be estimated reliably and it is not probable that the costs incurred will be recovered revenue is not recognised and the costs incurred are recognised as an expense. When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue is recognised in accordance with the main principle on recognising revenue on rendering of services rather than in accordance with the above descriptions Nelson 41 Revenue Rendering of Services Case Sino Land Company Limited 2005 Annual Report stated that: Building management and service fee income is recognised on an appropriate basis over the relevant period in which the services are rendered Nelson 42 21

22 Revenue Interest, Royalties & Dividend Sale of goods Rendering of services Interest, royalties and dividend Nelson 43 Revenue Interest, Royalties & Dividend Main Principle Revenue arising from the use by others of entity assets yielding interest, royalties and dividends shall be recognised on the bases set out in the following paragraph when: a) it is probable that the economic benefits associated with the transaction will flow to the entity; and b) the amount of the revenue can be measured reliably. Revenue shall be recognised on the following bases: a) interest t shall be recognised using the effective interest t method as set out in HKAS 39, paragraphs 9 and AG5-AG8; b) royalties shall be recognised on an accrual basis in accordance with the substance of the relevant agreement; and c) dividends shall be recognised when the shareholder s right to receive payment is established Nelson 44 22

23 Revenue Interest, Royalties & Dividend Interests When unpaid interest has accrued before the acquisition of an interestbearing investment, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods only the post-acquisition portion is recognised as revenue Nelson 45 Revenue Interest, Royalties & Dividend Example Amortised Cost on Low Interest Loan Entity A grants a 3-year loan of HK$50,000 to an important new customer in 1 Jan The interest rate on the loan is 4% The current market lending rates for similar loans is 6% Entity A believes that the future business to be generated with this new customer will lead to a profitable lending relationship. On initial recognition, Entity A recognised $47,327 (as calculated below): Cash inflow Discount factor Present value $ 50,000 x 4% = $ 2,000 1 / (1 + 6%) 1 $ 1, $ 2,000 1 / (1 + 6%) 2 $ 1, $ 52,000 1 / (1 + 6%) 3 $ 43,660 Calculate the amortised cost each year end. Fair value at initial recognition $ 47, Nelson 46 23

24 Revenue Interest, Royalties & Dividend Example Effective Interest Balance b/f interest (6%) received (4%) Balance c/f $ 47,327 $ 2,840 ($ 2,000) $ 48, $ 48,167 $ 2,890 ($ 2,000) $ 49, $ 49,057 $ 2,943 ($ 2,000) $ 50,000 For example, at , the entry is: Dr Loans receivable ($47,327 x 6%) 2,840 Cr Interest income (P/L) 2,840 Being effective interest income recognised for the year. Dr Cash (interest received, $50,000 x 4%) 2,000 Cr Loans receivable 2,000 Being cash interest received Nelson 47 Revenue Interest, Royalties & Dividend Dividends When dividends on equity securities are declared from pre-acquisition profits those dividends are deducted from the cost of the securities. If it is difficult to make such an allocation except on an arbitrary basis dividends are recognised as revenue unless they clearly represent a recovery of part of the cost of the equity securities Nelson 48 24

25 Revenue Interest, Royalties & Dividend Recognition of Royalties Over the Terms of Agreement Royalties Royalties accrue in accordance with the terms of the relevant agreement and are usually recognised on that basis unless, having regard to the substance of the agreement, it is more appropriate to recognise revenue on some other systematic and rational basis Nelson 49 Revenue Interest, Royalties & Dividend Inflow of Future Economic Benefits Not Probable Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in revenue the uncollectible amount, or the amount in respect of which recovery has ceased to be probable, is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised No offsetting Nelson 50 25

26 Revenue Disclosure An entity shall disclose: a) the accounting policies adopted for the recognition of revenue including the methods adopted to determine the stage of completion of transactions involving the rendering of services; b) the amount of each significant category of revenue recognised during the period including revenue arising from: i) the sale of goods; ii) the rendering of services iii) interest; iv) royalties; v) dividends; and c) the amount of revenue arising from exchanges of goods or services included in each significant category of revenue Nelson 51 Revenue Disclosure An entity discloses any contingent liabilities and contingent assets in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets. Contingent liabilities and contingent assets may arise from items such as warranty costs, claims, penalties or possible losses Nelson 52 26

27 HK Interpretation 3 Pre-completion Contracts for the Sale of Development Properties Background Requirements under current framework Conclusion in Interpretation Nelson 53 HK Interpretation 3 Property development projects are usually long term projects. In many cases, property developers would enter into contracts to sell the properties in advance of the completion of the development usually involve the payment of a deposit by the purchaser payment may be refundable only if the developer does not complete the development in accordance with the contracted timeframes and specifications, or if there is some other breach of a contractual condition or statutory obligation. The balance of the purchase price is normally paid either at contractual settlement or in stages up to contractual settlement Nelson 54 27

28 HK Interpretation 3 Case Property developers used to adopt various policies for recognising revenue arising from pre-completion contracts for the sale of development properties. p The stage of completion method was a commonly used policy. Full completion method was another one used by some companies. Stage of Completion Full Completion Nelson 55 HK Interpretation 3 Case Annual Report 2003/04 stated that: Profit on pre-sale of properties under development for sale is recognised over the course of the development and is calculated each year as a proportion of the total estimated profit to completion, the proportion used being the lower of Stage of Completion the proportion of construction costs incurred at the balance sheet date to estimated total construction costs and the proportion of sales proceeds received and receivable at the balance sheet date to total sales proceeds in respect of the units sold Nelson 56 28

29 HK Interpretation 3 Case 2004 Annual Report set out that: When properties under development are sold, income is recognised when the property is completed and the relevant occupation permit is issued by the Authorities. Payments received from the purchasers prior to this stage are recorded as customers deposits received and are deducted from the value of stock of properties. Full Completion Nelson 57 Concerns & Construction Contract Concern has been expressed as to whether the pre-completion contracts would satisfy the definition of construction contracts in HKAS 11 Construction Contracts and if not, whether the stage of completion method would be acceptable under HKFRSs. Concern has also been expressed, in the absence of authoritative guidance, that diverse or unacceptable practices would undermine the relevance, reliability or comparability of financial statements. Qualitative Characteristics of Financial Statements Nelson 58 29

30 Concerns & Construction Contract Concern has been expressed as to whether the pre-completion contracts would satisfy the definition of construction contracts in HKAS 11 Construction Contracts and if not, whether the stage of completion method would be acceptable under HKFRSs. Definition fulfilled by property developers in HK? A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use Nelson 59 Conclusion by HK Interpretation 3 Pre-completion contracts for the sale of development properties do not meet the definition of construction contracts, if the contracts in question are not specifically negotiated for the construction of the properties. Definition fulfilled by property developers in HK? Accordingly, these contracts fall outside the scope of HKAS 11 and, as a result, the stage of completion method as required under HKAS 11 shall not be used to recognise revenue arising from such contracts. Then Nelson 60 30

31 Conclusion by HK Interpretation 3 Property developers shall apply HKAS 18 in recognising revenue arising from pre-completion p contracts for the sale of development properties that do not fall within the scope of HKAS 11, and accordingly, recognise revenue only when all of the criteria specified in HKAS are met. All criteria in para. 14 of HKAS 18? Nelson 61 HKAS Back to HKAS 18, HKAS sets out that: Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied: a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; c) the amount of revenue can be measured reliably; d) it is probable that the economic benefits associated with the transaction will flow to the entity; and e) the costs incurred or to be incurred in respect of the transaction can be measured reliably All criteria in para. 14 of HKAS 18? Nelson 62 31

32 HK Interpretation 3 Case Implication to them? Nelson 63 HK Interpretation 3 Case Annual Report 2003/04 stated that: Profit on pre-sale of properties under development for sale is recognised over the course of the development and is calculated each year as a proportion of the total estimated profit to completion But Annual Report 2004/05 changed to that: With the introduction of the HK Interpretation 3 Revenue Pre-Completion contracts for the sale of development properties issued by the HKICPA, the Group now recognises revenue arising from pre-sale of properties upon completion of the development of property Nelson 64 32

33 Construction Contract (HKAS 11) Nelson 65 Objective and Scope The objective of HKAS 11 is to prescribe the accounting treatment of revenue and costs associated with construction contracts. The primary issue in accounting for construction contracts is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed. HKAS 11 shall be applied in accounting for construction contracts in the financial statements of contractors Nelson 66 33

34 What is Contraction Contract? A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. There are usually 2 kinds of contracts: A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, t which h in some cases is subject to cost escalation clauses. A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee Nelson 67 What is Contraction Contract? For the purposes of HKAS 11, construction contracts include: a) contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and b) contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets. Rendering of Services Destruction Restoration Nelson 68 34

35 Combining or Segmenting? Example In 2005, Entity A signed a construction contract of HK$50 million with Entity B to build an estate in Cheung Sa Entity A finished the foundation work and received the down payments of HK$10 million Entity B requires Entity A to transfer the finished properties of the whole estate to it by 3 phases. Discuss the implication to Entity A Nelson 69 Combining or Segmenting? The requirements of HKAS 11 are usually applied separately to each construction contract. However, in certain circumstances, it is necessary to apply HKAS 11 to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts. Each part of a single contract 2 or more contracts together Nelson 70 35

36 Combining or Segmenting? When a contract covers a number of assets, the construction of each asset shall be treated as a separate construction contract when: a) separate proposals have been submitted for each asset; b) each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset; and c) the costs and revenues of each asset can be identified. Each part of a single contract Nelson 71 Combining or Segmenting? A group of contracts, whether with a single customer or with several customers, shall be treated as a single construction contract when: a) the group of contracts is negotiated as a single package; b) the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and c) the contracts are performed concurrently or in a continuous sequence. 2 or more contracts together Nelson 72 36

37 Combining or Segmenting? A contract may provide for the construction of an additional asset at the option of the customer or may be amended to include the construction of an additional asset. The construction of the additional asset shall be treated as a separate construction contract when: a) the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or b) the price of the asset is negotiated without regard to the original contract price Nelson 73 Contract Revenue & Contract Cost Example In 2005, Entity A signed a construction contract of HK$50 million with Entity B to build an estate in Cheung Sa Entity A finished the foundation work and received the down payments of HK$10 million In 2006, Entity B could not source sufficient funds to continue the project and abolished the project. Entity A received HK$5 million compensation from Entity B on 30 June Discuss the implication Nelson 74 37

38 Contract Revenue & Contract Cost Contract revenue shall comprise: a) The initial amount of revenue agreed in the contract; and b) Variations in contract work, claims and incentive payments: i) to the extent that it is probable that they will result in revenue; and ii) they are capable of being reliably measured. Contract costs shall comprise: a) costs that relate directly to the specific contract; b) costs that are attributable to contract activity in general and can be allocated to the contract; and c) such other costs as are specifically chargeable to the customer under the terms of the contract Nelson 75 Contract Revenue & Contract Cost Case Annual Report 2005 Contract revenue comprises the agreed contract amount and appropriate amounts from variation orders, claims and incentive payments. Contract costs incurred comprise direct materials, the costs of subcontracting, direct labour and an appropriate proportion of variable and fixed construction overheads Nelson 76 38

39 Recognition of Contract Revenue and Cost Estimated Reliably Stage of Completion When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date. An expected loss on the construction contract shall be recognised as an expense immediately in accordance with HKAS Nelson 77 Recognition of Contract Revenue and Cost Example Estimated Reliably Fixed Price Contract Cost Plus Contract How can we fulfil estimated reliably? Assuming Entity A enters into a construction contract with Entity X Entity X would pay all the contract revenue at the inception of the contract Entity A would incur the cost and finish it as soon as possible. At year end, 80% of the contract has been completed Can Entity A recognize 80% of the contract revenue and cost? Any differences between Fixed price contract, and Cost plus contract For example, if Entity A can recharge any additional cost to Entity X Nelson 78 39

40 Recognition of Contract Revenue and Cost In the case of a fixed price contract, the outcome Estimated of a construction contract can be estimated Reliably reliably when all the following conditions are satisfied: Fixed Price a) total contract revenue can be measured reliably; Contract b) it is probable that the economic benefits associated with the contract will flow to the entity; c) both the contract costs to complete the contract and the stage of contract completion at the balance sheet date can be measured reliably; and d) the contract t costs attributable t bl to the contract t can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates Nelson 79 Recognition of Contract Revenue and Cost In the case of a cost plus contract, the outcome Estimated of a construction contract can be estimated Reliably reliably when all the following conditions are satisfied: a) it is probable that the economic benefits associated with the contract will flow to the entity; and b) the contract costs attributable to the contract, Cost Plus whether or not specifically reimbursable, can be Contract clearly identified and measured reliably Nelson 80 40

41 Recognition of Contract Revenue and Cost Estimated Reliably Fixed Price Contract Cost Plus Contract The outcome of a construction contract can only be estimated reliably when it is probable that the economic benefits associated with the contract will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in contract revenue, and already recognised in the income statement, the uncollectable amount or the amount in respect of which recovery has ceased to be probable is recognised as an expense rather than as an adjustment of the amount of contract revenue Nelson 81 Recognition of Contract Revenue and Cost Estimated Reliably Stage of Completion The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method Nelson 82 41

42 Recognition of Contract Revenue and Cost The stage of completion of a contract may be determined in a variety of ways. The entity uses the method that measures reliably the work performed. Depending on the nature of the contract, the methods may include: a) the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs; b) surveys of work performed; or c) completion of a physical proportion of the contract work. Cost Incurred To Date Survey of Work Physical Proportion Nelson 83 Recognition of Contract Revenue and Cost On 1 Jan. 2001, Vision Corp. signed a construction contract with a customer for 3 years with an agreed contract consideration of HK$200 million. The cost of the contract was estimated at HK$150 million. During the year to 31 Dec. 2001, Vision Corp. incurred contract cost of HK$70 million. The surveyor certified that 40% of the contract work had been completed on 31 Dec On 31 Dec. 2001, Vision Corp. received a progress payment of HK$100 million. Which basis can be used as stage of completion of the contract? Example $70 / $150 = 46.7% Surveys of work = 40% Progress payments and advances received from customers often do not reflect the work performed.? Nelson 84 42

43 Recognition of Contract Revenue and Cost Case Annual Report 2004/05 Accounting policy on construction Revenue in respect of building construction job is recognized on the percentage of completion method measured by reference to the proportion that costs incurred to date bear to estimated total costs for the contract. Cost Incurred To Date Nelson 85 Recognition of Contract Revenue and Cost Case Annual Report 2005 Revenue from fixed price construction contracts is recognised on the percentage of completion method, measured by reference to the proportion of costs incurred to date to the estimated total cost of the relevant contract. Revenue from cost plus construction ti contracts t is recognised on the percentage of completion method, by reference to the recoverable costs incurred during the period plus the related fee earned, measured by the proportion of costs incurred to date to the estimate total cost of the relevant contract. Cost Incurred To Date Nelson 86 43

44 Recognition of Contract Revenue and Cost Case Annual Report 2005 Accounting policy on construction revenue Revenue from a fixed price contract is recognized using the percentage of completion method, measured by reference to the percentage of estimated value of work performed to date to total contract revenue. Physical Proportion Nelson 87 Recognition of Contract Revenue and Cost When the outcome of a construction contract cannot be estimated reliably: a) revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and b) contract costs shall be recognised as an expense in the period in which they are incurred. An expected loss on the construction contract shall be recognised as an expense immediately in accordance with HKAS 11. When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue and expenses associated with the construction contract shall be recognised in as usual rather than as above Nelson 88 44

45 Recognition of Expected Losses When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately. The amount of such a loss is determined irrespective of: a) whether work has commenced on the contract; b) the stage of completion of contract activity; or c) the amount of profits expected to arise on other contracts which are not treated as a single construction contract in accordance with HKAS Nelson 89 Recognition of Expected Losses Case Annual Report 2005 Provision is made for foreseeable losses as soon as they are anticipated by management. Where contract costs incurred to date plus recognised profits less recognised losses exceed progress billings, the surplus is treated as an amount due from customer for contract work. Where progress billings exceed contract costs incurred to date plus recognised profits less recognised losses, the surplus is treated as an amount due to customer for contract work Nelson 90 45

46 Changes in Estimates The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates on contract revenue and contract costs. Therefore, the effect of a change in the estimate of contract revenue or contract costs, or the effect of a change in the estimate on the outcome of a contract, is accounted for as a change in accounting estimate (see HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors). ) The changed estimates are used in the determination of the amount of revenue and expenses recognised in the income statement in the period in which the change is made and in subsequent periods Nelson 91 Disclosure An entity shall disclose: a) the amount of contract revenue recognised as revenue in the period; b) the methods used to determine the contract revenue recognised in the period; and c) the methods used to determine the stage of completion of contracts in progress. An entity shall disclose each of the following for contracts in progress at the balance sheet date: a) the aggregate amount of costs incurred and recognised profits (less recognised losses) to date; b) the amount of advances received; and c) the amount of retentions. An entity shall present: a) the gross amount due from customers for contract work as an asset; and b) the gross amount due to customers for contract work as a liability Nelson 92 46

47 Disclosure The gross amount due from customers for contract work is the net amount of: a) costs incurred plus recognised profits; less b) the sum of recognised losses and progress billings for all contracts in progress for which costs incurred plus recognised profits (less recognised losses) exceeds progress billings. The gross amount due to customers for contract work is the net amount of: a) costs incurred plus recognised profits; less b) the sum of recognised losses and progress billings for all contracts in progress for which progress billings exceed costs incurred plus recognised profits (less recognised losses). An entity discloses any contingent liabilities and contingent assets in accordance with HKAS 37. Contingent liabilities and contingent assets may arise from such items as warranty costs, claims, penalties or possible losses Nelson 93 Disclosure Case Annual Report 2005 Accounting policy on construction contract Construction contracts in progress at the balance sheet date are recorded in the balance sheet at the net amount of costs incurred plus recognized profit less recognized losses and estimated value of work performed, including progress billing, and are presented in the balance sheet as the Gross amount due from customers for contract work (as an asset) or the Gross amount due to customers for contract work (as a liability), as applicable. Progress billings for work performed on a contract not yet paid by customers are included in the balance sheet under Prepayments, deposits and other current assets Nelson 94 47

48 Construction Contract As set out before, on 1 Jan. 2001, Vision Corp. signed a construction contract with a customer for 3 years with an agreed contract consideration of HK$200 million. The cost of the contract was estimated at HK$150 million. During the year to 31 Dec. 2001, Vision Corp. incurred contract cost of HK$70 million. The surveyor certified that 40% of the contract work had been completed on 31 Dec On 31 Dec. 2001, Vision Corp. received a progress payment of HK$100 million. Prepare the journal entries and extract of financial statements of Vision Corp. for the year ended 31 Dec Assumed that the percentage of completion of the contract is based on the work certified by an independent surveyor appointed by the customer. Example Surveys of work = 40% Nelson 95 Construction Contract Example Dr HK$ M Cr HK$ M Cash 100 Progress payments 100 To recognize progress payments received Cost to date70 Cash 70 To account for cost incurred to Contract cost (40% x $150 million) 60 Recognized profit 20 Contract revenue (40% x $200 million) 80 To recognize profit on the contract Nelson 96 48

49 Construction Contract Example Income statement (Extract only) HK$ M Contract revenue 80 Contract t cost (60) Recognized profit 20 Balance sheet (Extract only) HK$ M Gross amounts due from/to customers Cost incurred to date 70 Recognized profit Less: Progress payments (100) Gross amounts due to customers (10) Note: Gross amounts were in credit balance at year end and hence gross amounts due to customers were shown at year end Nelson 97 HK Interpretation 1 The Appropriate Policies for Infrastructure Facilities Nelson 98 49

50 HK Interpretation 1 Sinking Fund Some companies in HK have adopted Sinking Fund Method in depreciating their infrastructure facilities, in particular toll roads, in their financial i statements t t purporting to be in compliance with HKFRSs. Such companies disclosed an accounting policy that the capital cost of an infrastructure asset was allocated by applying a sinking fund method whereby the aggregate annual depreciation amounts, compounded at certain rates of return, up to the expiry of the infrastructure asset (e.g. toll road) concession periods, will be equal to the total cost of the asset Nelson 99 HK Interpretation 1 Sinking Fund Example A machine costs HK$600,000 with an estimated useful life of 3 years? Calculate deprecation for the years under difference depreciation methods. Year 1 Year 2 Year 3 Total Straight-line basis Reducing balance (at 70%) Sum-of-year-digit Sinking fund (compounded at 23.2%) (160 x 123.2%) (197 x 123.2%) Sinking fund method allocates more depreciation to the later years. It is different from most depreciation methods (as above) Nelson

51 HK Interpretation 1 Sinking Fund Case Some listed companies stated that they had used a sinking fund method Nelson 101 HK Interpretation 1 Sinking Fund Case 2002 Annual Report of Anhui Expressway Co. Ltd. stated that: Depreciation of toll roads and amortisation of land use rights in relation to toll roads are calculated l to write off their cost on the basis of a sinking fund calculation whereby annual depreciation amounts compounded at an average rate of 7%, 6%, 3% and 4% per annum for Hening Expressway, 205 Tian Chang Section, Xuan Guang Expressway and Gao Jie Expressway respectively will approximate the total carrying value of the toll roads and the land use rights in relation to toll roads at the end of operating periods of respective toll roads. Please comment Nelson

52 HK Interpretation 1 Sinking Fund Case Depreciation on its tunnels 2002 Annual Report: Amortisation of vehicular tunnel (including land and buildings) is provided for over the franchise period on the basis of a sinking fund calculation whereby annual amounts compounded at the rate of 7% per annum will equal the net cost of the tunnel Annual Report: Depreciation of the vehicular tunnel was provided with reference to projected usage of the tunnel through a sinking fund calculation Annual Report: Depreciation of the vehicular tunnel was provided with reference to projected usage of the tunnel as compared to the actual tunnel usage Nelson 103 Conclusion by HK Interpretation 1 HK Int. 1 concludes that: The Sinking Fund Method is NOT an appropriate method of depreciating or amortising infrastructure assets, regardless of whether the asset (or components thereof) is classified as property, plant and equipment, intangible assets or operating lease prepayments. By definition, the sinking fund method neither supports the view that consumption of economic benefits (such as in a Build- Operate-Transfer franchise) is determined by either the passage of time and/or usage. Sinking Fund Nelson

53 Conclusion by HK Interpretation 1 Case 2004 Annual Report of Anhui Expressway Co. Ltd. stated that: Depreciation of toll roads and land use rights in relation to toll roads is calculated to write off their cost on a units-of-usage basis whereby depreciation is provided based on the share of traffic volume for a particular period over the projected total traffic volume throughout the periods for which the Group is granted the rights to operate those roads. It is the Group s policy to review regularly the projected total traffic volume throughout the operating periods of the respective toll roads. If it is considered appropriate, independent professional traffic studies will be obtained. Appropriate adjustment will be made should there be a material change. Changed to units-of-usage basis Nelson 105 Borrowing Costs (HKAS 23) Amendments to IAS 23 issued in March 2007 and HK? Nelson

54 Topics Covered 1. Objective and scope 2. What are borrowing costs? 3. Benchmark treatment: Expense 4. Allowed alternative ti treatment: t t Capitalisation ti Nelson Objective and Scope The objective of HKAS 23 is to prescribe the accounting treatment for borrowing costs. HKAS 23 generally requires the immediate expensing of borrowing costs, but permits, as an allowed alternative treatment, the capitalisation of borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset. HKAS 23 shall be applied in accounting for borrowing costs, but does not deal with the actual or input cost of equity, including preferred capital not classified as a liability. Benchmark Expenses Allowed Alternative Capitalisation Nelson

55 2. What Are Borrowing Costs? Borrowing costs are interest and other costs incurred by an entity in connection with the borrowing of funds. may include: a) interest on bank overdrafts and short-term and long-term borrowings; b) amortisation of discounts or premiums relating to borrowings; c) amortisation of ancillary costs incurred in connection with the arrangement of borrowings; d) finance charges in respect of finance leases recognised in accordance with HKAS 17 Leases; and e) exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs Nelson Benchmark Treatment: Expense Recognition Borrowing costs shall be recognised as an expense in the period in which they are incurred. Under the benchmark treatment borrowing costs are recognised as an expense in the period in which they are incurred regardless of how the borrowings are applied. Disclosure The financial statements shall disclose the accounting policy adopted for borrowing costs. Benchmark Expenses Nelson

56 3. Benchmark Treatment: Expense Amendments to IAS 23 issued in March 2007 Converged to the practice in US HK should follow soon Apply to borrowing costs relating to qualifying assets for which it begins capitalisation on or after 1 January 2009 Remove the option of immediately recognising the borrowing costs as expenses IAS 23 does not apply to borrowing costs directly attributable t bl to the acquisition, iti construction ti and production of a qualifying assets measured at fair value, say biological asset Benchmark Expenses Nelson Allowed Alternative: Capitalise Recognition Borrowing costs shall be recognised as an expense in the period in which they are incurred, except to the extent that they are capitalised in accordance with HKAS 23. What kinds of borrowing costs eligible for capitalisation? When does capitalisation commence? When does capitalisation suspense? When does capitalisation cease? Allowed Alternative Capitalisation Nelson

57 4. Allowed Alternative: Capitalise Recognition Eligible Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset. The amount of borrowing costs eligible for capitalisation shall be determined in accordance with HKAS 23. Qualifying Asset Attributable borrowing cost Allowed Alternative Capitalisation Nelson Allowed Alternative: Capitalise Recognition Eligible Qualifying Asset A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Under the allowed alternative treatment, borrowing costs that are directly attributable to the acquisition, construction or production of an asset are included in the cost of that asset. Such borrowing costs are capitalised as part of the cost of the asset when it is probable that they will result in future economic benefits to the entity and the costs can be measured reliably. Other borrowing costs are recognised as an expense in the period in which they are incurred. Other to be expensed Nelson

58 4. Allowed Alternative: Capitalise Example Recognition Eligible Examples of qualifying assets: Inventories that require a substantial period of time to bring them to a saleable condition Manufacturing plants, Power generation facilities Investment properties Qualifying Asset Examples of items cannot be qualifying assets: Other investments, and those inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time Assets that are ready for their intended use or sale when acquired also are not qualifying assets Nelson Allowed Alternative: Capitalise Recognition Eligible Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made. Qualifying Asset Attributable borrowing cost When an entity borrows funds specifically for the purpose p of obtaining a particular qualifying asset, the borrowing costs that directly relate to that qualifying asset can be readily identified Nelson

59 4. Allowed Alternative: Capitalise Recognition Eligible It may be difficult to identify a direct relationship between particular borrowings and a qualifying asset and to determine the borrowings that could otherwise have been avoided. e.g. when the financing activity of an entity is coordinated centrally. Difficulties also arise when a group uses a range of debt instruments to borrow funds at varying rates of interest, and lends those funds on various bases to other entities in the group. Other complications arise through the use of loans denominated in or linked to foreign currencies, when the group operates in highly inflationary economies, and from fluctuations in exchange rates. As a result, the determination of the amount of borrowing costs that are directly attributable to the acquisition of a qualifying asset is difficult and the exercise of judgement is required Nelson Allowed Alternative: Capitalise Recognition Eligible Borrowing costs may be incurred from 2 sources in obtaining a qualifying asset: 1. Borrowed specifically for obtaining a qualifying asset 2. Borrowed generally and used for obtaining a qualifying asset Qualifying Asset Attributable borrowing cost To the extent that funds are borrowed specifically for the purpose of obtaining a qualifying asset the amount of borrowing costs eligible for capitalisation on that asset shall be determined as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings Nelson

60 4. Allowed Alternative: Capitalise Recognition Eligible The financing arrangement for a qualifying asset may result in an entity obtaining borrowed funds and incurring associated borrowing costs before some or all of the funds are used for expenditures on the qualifying asset. In such circumstances, the funds are often temporarily invested pending their expenditures on the qualifying asset. In determining the amount of borrowing costs eligible for capitalisation during a period, any investment income earned on such funds is deducted from the borrowing costs incurred. Qualifying Asset Attributable borrowing cost Nelson Allowed Alternative: Capitalise Case Borrowing costs are expensed in the income statement in the period in which they are incurred, except to the extent that they are capitalized as being attributable to the acquisition, construction or production of an asset which necessarily takes a substantial period of time to get ready for its intended use or sale Nelson

61 4. Allowed Alternative: Capitalise Case Beijing Enterprises Holdings Ltd. Has early adopted all new HKFRS in 2004 and stated that: Borrowing costs directly attributable to the acquisition, construction or production of qualifying assets, i.e., assets that necessarily take a substantial period of time to get ready for their intended use or sale, are capitalized as part of the cost of those assets Investment income earned on the temporary investment of specific borrowings pending their expenditure on qualifying assets is deducted from the borrowing costs capitalized Nelson Allowed Alternative: Capitalise Recognition Eligible Borrowing costs may be incurred from 2 sources in obtaining a qualifying asset: 1. Borrowed specifically for obtaining a qualifying asset 2. Borrowed generally and used for obtaining a qualifying asset Qualifying Asset Attributable borrowing cost To the extent that funds are borrowed generally and used for the purpose of obtaining a qualifying asset the amount of borrowing costs eligible for capitalisation shall be determined by applying a capitalisation rate to the expenditures on that asset Nelson

62 4. Allowed Alternative: Capitalise Recognition Eligible Borrowing costs may be incurred from 2 sources in obtaining a qualifying asset: 1. Borrowed specifically for obtaining a qualifying asset 2. Borrowed generally and used for obtaining a qualifying asset Qualifying Asset Attributable borrowing cost The capitalisation rate shall be the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. The amount of borrowing costs capitalised during a period shall not exceed the amount of borrowing costs incurred during that period Nelson Allowed Alternative: Capitalise Recognition Eligible In some circumstances, it is appropriate to include all borrowings of the parents and its subsidiaries when computing a weighted average of the borrowing costs In other circumstances, it is appropriate for each subsidiary to use a weighted average of the borrowing costs applicable to its own borrowings. Qualifying Asset Attributable borrowing cost Nelson

63 4. Allowed Alternative: Capitalise Recognition Excess of the Carrying Amount of the Qualifying i Asset over Recoverable Amount When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its recoverable amount or net realisable value the carrying amount is written down or written off in accordance with the requirements of other HKFRSs. In certain circumstances, the amount of the write-down or write-off is written back in accordance with those other HKFRSs. Qualifying Asset Attributable borrowing cost Allowed Alternative Capitalisation Nelson Allowed Alternative: Capitalise Recognition Commence The capitalisation of borrowing costs as part of the cost of a qualifying asset shall commence when: a. expenditures for the asset are being incurred; b. borrowing costs are being incurred; and c. activities that are necessary to prepare the asset for its intended use or sale are in progress. Qualifying Asset Attributable borrowing cost Allowed Alternative Capitalisation Nelson

64 4. Allowed Alternative: Capitalise Example Entity A constructs a scientific medical equipment for its own use, with a cost of HK$50 million and consider it as a qualified asset. Borrowing costs capitalised under HKAS 23 amounts to HK$6 million. It also receives a government grant of HK$5 million on that asset. Can the government grant received be recognised as part of the expenditure on qualified asset? Expenditures on a qualifying asset include only those expenditures that have resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities. are reduced by any progress payments received and grants received in connection with the asset (see HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance) Nelson Allowed Alternative: Capitalise Example Before the construction of a property in a land, Entity GV has to prepare the construction plan and get the government approval. Borrowing costs have been incurred during the above period. Are these borrowing costs eligible for capitalisation under HKAS 23? Yes The activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. They include technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset's condition is taking place Nelson

65 4. Allowed Alternative: Capitalise Recognition Suspense Capitalisation of borrowing costs shall be suspended during extended periods in which active development is interrupted. Except for the following: Not normally suspended during a period when substantial technical and administrative work is being carried out. Not suspended when a temporary delay is a necessary part of the process of getting an asset ready for its intended use or sale Nelson Allowed Alternative: Capitalise Recognition Cease Capitalisation of borrowing costs shall cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. When the construction of a qualifying asset is completed in parts and each part is capable of being used while construction continues on other parts, capitalisation of borrowing costs shall cease when substantially all the activities necessary to prepare that part for its intended use or sale are completed Nelson